The Theory of Money, Part 17

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Last week, we went from one bank to five banks in a pretty short time. We also saw that the bankers and their investors started getting greedy, pushing their reserve ratios down lower and lower. I described it as a house of cards.

So what will we do this week to try to topple this house of cards?

Let’s say the farmer has a bad crop. Maybe there was an early frost. These things happen. And it means that one of the primary sources of new wealth for the society didn’t produce as much this year. Unfortunately, a lot of people were planning on that additional wealth coming into society, so let’s trace the ripple effects of this bad crop!

First, the farmer, ever since buying the tractor and expanding his farm, has been hiring a lot of farm hands lately. Suddenly he doesn’t need them for several months.

And then there are all of the people who are normally employed to help transport and process and re-sell all the food the farmer harvests. They all lose a large portion of their income as well.

When you start adding up all the people who just lost some or all of their annual income, it comprises a large minority of society. And what do people do when they are suddenly impoverished? They especially cut back on luxury items.

With business previously booming in society, there were a lot of companies selling luxury items and growing quickly, and they were borrowing a lot of money to rapidly increase production capacity. Suddenly their sales have dropped precipitously, and they can’t afford to make their loan payments. Some factories that were half-built have to be scrapped entirely. What a loss of Labor Units! This, remember, is in addition to the loss of Labor Units (relative to expectations) that the farmer would normally provide.

So now we have a lot of businesses defaulting on their loans, and surely a lot of families as well. Therefore, commercial loan and private mortgage defaults start rising quickly. And who do you think gets hit the hardest by all these loan defaults? Yes, of course, it’s the people who own all the loans–the bankers. They, after all, are the ones lending out the majority of money in society.

Let’s say the problems start with Indie Bank. As the newest bank, it was being extra aggressive to try to play catch up with the other banks and earn its fair share of the market, so it was pushing its reserve ratios the lowest. Then, many of its loans go bad. It has been counting on getting paid back those Goldnotes it lent out so it can continue to pay its employees and other expenses. But now it doesn’t have enough of those, so it resorts to paying in gold coins directly from the vault. This, in addition to the usual exchange requests, drops the number of gold coins to only a few small piles.

One of the employees walks into the vault and sees that the bank is running out of gold. He runs home and tells his family members that they better exchange their Indie Bank Goldnotes quickly because the bank is going to run out of gold coins soon. So they all run to the bank and line up, asking for specie in exchange for all their Indie Bank Goldnotes. Other passersby see the line and ask what’s going on, and the people in line tell them the bank is running out of gold and that they better redeem their Indie Bank Goldnotes quickly.

The news spreads, and the line grows longer. Within another few hours, Indie Bank is going to be completely out of gold, which would mean telling its depositors that they can’t get specie anymore and then having to liquidate its assets to try to repay them.

This is our fictitious society’s first bank run! How exciting, right?

Does this mean we have a societal default on our hands? There are a lot of people defaulting on loans, but I would say it hasn’t necessarily led to a full-blown societal default yet.

But never fear–the owners of all the banks see what’s happening. They see that this could go downhill for all banks real quick if people start worrying about the reserves in them as well. That means their entire system of massive wealth generation for themselves (i.e., fractional reserve banking, the house of cards) could completely topple! They need a solution, and fast. We’ll see what they decide to do next week. (It feels like this is where I should add, “Same bat time, same bat channel.”)

The Theory of Money, Part 16

As I promised last week at the end of Part 15, I went back and read through Parts 10-15 again to see if I’ve missed anything important that came about as a result of the institution of fractional reserve banking.

I only had two small thoughts to add to all of that.

The first is that bankers really love fractional reserve banking. Think about it: All wealth (Labor Units) in society is stored either in the form of cash assets or non-cash assets, and the banker is earning interest on a large percentage of the entire cash assets in the society. In the case of Pepper Bank, he was earning interest on 23,000 of the total 33,000 Goldnotes in circulation, which is 70% of the entire cash assets of the society! Wow.

Here’s a new formula I’ll introduce to help you quickly calculate that:

Portion of Society’s Total Cash Wealth that Bankers Took from Others and Are Earning Interest On = 1 – Reserve Ratio

That formula does assume everyone has deposited all their gold coins into Pepper Bank, so maybe the number ends up being a little less. But still, that’s why bankers can get very rich off of fractional reserve banking.

The second thought I wanted to mention is that I haven’t clarified exactly why unstable prices are so inefficient for an economy. I have, however, written before about the importance of prices being accurate, and there may be an opportunity to further illustrate that principle before this series ends. We will see.

All right, it’s finally time to get back to the story of our fictitious society and see what monetary changes arise next! (It only took 5 posts to unpack all the changes that came about as a result of instituting fractional reserve banking, which I’d say isn’t too bad.)

Maybe you can guess what happens after the banker starts earning all that money from interest on the 23,000 Goldnotes he printed and lent out. People start seeing that he’s earning a lot of money. They eventually figure out what he’s done, and the clever ones figure out a great secret: They can start a bank and do the same thing!

The town storyteller decides he has lots of rich friends who pay him to tell them stories, and he’s not earning enough just telling stories, so he uses his persuasive speaking skills to get them to invest in a new bank. He names it Story Bank. He spends the investment money on a beautiful new bank building with a nice big modern and extra-safe vault in it, and he designs a more beautiful banknote that, for simplicity, he also decides to call a Goldnote (but there’s the seal of Story Bank on this one instead of the Pepper Bank seal).

Through all these efforts, plus on the recommendation from all the rich influential people who just invested in the bank, many people start choosing to store their gold coins in Story Bank instead of Pepper Bank.

Others do the same. There’s the town preacher who founds Verity Bank with the investment of his parishioners, and the Astrid Bank founded by the industrious Scandinavian immigrant community, and the Indie Bank founded by the musician who has some wealthy fans. All told, there are 5 banks at this point. Kind of overwhelming, really!

They all find their niches and start earning money for their investors by instituting fractional reserve banking. And they all closely track the variability in the amount of specie in their vault and lend out the maximum number of Goldnotes they can get away with, sometimes even pushing their reserve ratios down to below 15%. After all, their investors want as high of a return on their investment as possible, and the founders of all these banks made big promises to them.

I just want to pause briefly here and remind you what a 15% reserve ratio means. If all banks have a 15% reserve ratio, that means 85% of the money circulating is NOT backed by specie. The society’s money started out at 100% backing, then it dropped to 30% when Pepper Bank instituted fractional reserve banking, and now it’s at 15%.

Additionally, a 15% reserve ratio means banks are highly leveraged. 85% to be exact. This is obviously pretty high.

Meanwhile, business is booming in society. There’s so much capital available that new businesses are cropping up all over the place, everybody is hiring, and there’s excitement in the air. Sure, prices are rising like crazy (from the total number of circulating Goldnotes continuing to increase as reserve ratios drop), but that’s a small concern because money seems so plentiful everywhere. People don’t ask why there’s so much apparent wealth everywhere. Why question such a wonderful thing? They know that they’ve worked hard for so long as a society, their reward was bound to come sooner or later.

You can see where this is going. This house of cards is set to topple at the slightest provocation. We’ll give it a little push next week and see what happens!

The Theory of Money, Part 15

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I’ve been thinking more about how to clarify last week‘s topic of leverage and the risk for societal default, and I actually went back and edited last week’s post a little bit. And now I’ll clarify some terminology for easier referencing in the future.

The two main possible causes of a societal default are “bank leverage” and “government leverage.” Bank leverage is the percent of total cash that the bank created through fractional reserve banking. As a reminder, it’s calculated like this: 1 – Reserve Ratio = Bank Leverage. Government leverage is the percent of government income that has to go to servicing debts. As a reminder, it’s calculated like this: Government Monthly Debt Payments / Government Monthly Income = Government Leverage.

And then there was sort of a third contributor to the risk of societal default, which is the average amount of leverage of individuals in the society. I guess we could call it “individual leverage” (“average individual leverage” seemed too long of a name). It would be the same calculation as government leverage, only applied to an individual’s income and debt payments. This third kind of leverage can come into play and contribute to a societal default if a large percentage of people in the society owe a lot of money (i.e., the average individual leverage is high) because a hit to the economy may lead to a lot of people not being able to pay their loans, which will probably spark one or both of the other two forms of leverage that would cause the default to become more generalized, in which case it becomes a full-blown societal default.

Ok, nice and tidy. Bank leverage, government leverage, and individual leverage.

I also realized I had made an error in Part 13 when I talked about the auditing system, so I went back and clarified that part of that post. Basically, I forgot that Pepper Bank doesn’t have to keep track of any individual account balances anymore because the only way for someone to get a gold coin is to present a Goldnote. Modern-day banks do keep track of account balances though, so I explained how the auditing system would differ in that case.

All right, with those clarifications out of the way, and with the new terminology I defined above, I want to write just a little more about the two options for making use of all those piles of gold coins that were in Pepper Bank’s vault.

The first option, which is the one the banker chose, was to institute what we call fractional reserve banking. This created bank leverage that allowed for greater individual leverage (because now more cash was available for borrowing). Individual leverage is all well and good–people need to borrow money sometimes, especially for big expenditures like business ventures–but it’s the bank leverage that caused so many problems because it artificially expanded the total cash in society, which meant that each gold coin or Goldnote was worth much less, so people lost a lot of their LUs they’d been storing in cash and also prices became very unstable, which is very inefficient for a market.

The second option, which I described as a counterfactual in Part 12, was for the banker to get individuals to combine together to lend some of their savings to be able to fund some of those loan requests. Basically, I’m realizing now, it was a primitive version of Kickstarter. It’s crowdfunding. So, from this point on, this counterfactual will be referred to as the crowdfunding option. And it involves NO BANK LEVERAGE. But it of course still involves individual leverage because individual people are still borrowing money. The big downside is that there won’t be as much money made available for lending, but the money that is made available for lending is being proffered by people who are ok to give up some of their savings for a while, so an investment failure with complete loss of their money probably also won’t be so financially catastrophic in most cases.

Compare that to the impact of all people losing a large percentage of their stored LUs when the banker implements fractional reserve banking. Many of those people probably couldn’t stand to lose any of their LUs, and maybe a few richer members of society could have stood to give up more! But, unfortunately, regardless of which group a person is in, they don’t get any of the interest from their LUs being taken and lent out. Only the banker gets the benefits of lending out the depositors’ money. The best the people can hope for is that fractional reserve banking goes away after the loans are paid off so they at least can get their original LUs back when the gold coin:LU ratio goes back to how it was.

Switching back to the crowdfunding option, let’s look at this idea from the standpoint of my save, spend, or invest explanation from Part 4. The super brief refresher of that concept from Part 4 is this: When someone has money that they don’t need to use immediately, their 3 options are to save it, spend it, or invest it. So, thinking about the crowdfunding option, it’s giving people an opportunity to shift more of their stored wealth from the save category (where it’s doing nothing for them) to the invest category (where it’s earning more money for them). This is great!

You can probably see that I’ve come to believe that the crowdfunding option is a better solution than than the fractional reserve banking option. But I’m not blind to the big downside of the crowdfunding option, which is that less money will be made available for borrowing. But let’s think about that for a moment to see how big of a downside it really is.

If there is less money available for borrowing, it means not as many investment opportunities will get funded. The big question is whether the people who are making the decision about which investment opportunities to fund are correctly predicting the ones that will be the most successful. If they are doing a good job of that, then the investment opportunities that don’t get funded are the lower-yield ones that will have less of a benefit to society anyway. So how much are we losing if we only miss out on investing in the lower-quality investments? Maybe not so much.

Of course, there are always those investments that seem off the wall but get funded due to an excess of capital around and then end up paying off bigtime, so I can’t say for sure that avoiding bank leverage (which would make available a whole bunch more capital for lending) is the guaranteed best outcome for society.

So that’s the short-term analysis. Longer term, think about what is likely going to happen sooner or later with enough bank leverage: a societal default. No, we still haven’t talked about how this might happen! Trust me, we’re getting there. But anyway, when a societal default happens, it causes the wealth of a society to regress so much that you may end up further behind and have less wealth to invest overall than if you’d just stuck with the slower steadier crowdfunding option.

And there are other reasons to avoid a societal default. Not only will it cause the wealth of a society to regress, but also it creates massive amounts of suffering for those individuals and families who, maybe of no fault of their own, ended up getting hit the hardest and lost a lot of their wealth that was critical to their continued wellbeing.

Before I end this post, I want to address one more question that has arisen in my mind about all this. If a prudent amount of government leverage and individual leverage can be used beneficially, what about a prudent amount of bank leverage? Maybe just keep the reserve ratio nice and high so a bank failure is nearly impossible?

This could work, but don’t forget about the guaranteed costs of any amount of bank leverage: the change in the gold coin:LU ratio, which causes people to lose a percentage of their LUs that were stored in cash and that causes prices to become unstable. Government leverage and individual leverage don’t have these same guaranteed downsides. So I would say that bank leverage is a form of leverage that you cannot “use prudently” like the other two types. The guaranteed, significant, generalized downsides of bank leverage make it not worth whatever benefits you hope to get out of it.

All right, that’s it for this week. Eventually we’ll get back to seeing what happens next in our fictitious society, but there have been so many things to process with this major shift from receipt money to fractional reserve money that occurred way back in Part 10! Before I write next week’s post, I’ll go back through all those parts to see if there’s anything I’ve missed before I start progressing our fictitious society again.

The Theory of Money, Part 14

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Yes, I’m still going through my theory of money. (Here’s Part 13 from last week.) As a reminder, this is still primarily a health policy blog. But I share other interests here as well. And economics is a significant interest of mine! It’s the core of health policy, and it’s also the core of monetary policy. I have several weeks’ worth of thoughts on money still, so feel free to come back in a few months if this isn’t of interest to you. Once I’m done writing about money, I’ll clean up a few other topics in health policy and then start on a new longterm project going through all the foundational papers in the health policy and economics field and see what happens when I build my ideas about the healthcare system from scratch again. Or, you know, build them as much from scratch as a biased human with imperfect insight who is susceptible to the effects of cognitive dissonance can hope to achieve.

All right, a couple clarification topics up front, and then we’ll talk about societal leverage after those.

First clarification point: The impact of goods versus services on a society’s aggregate Labor Units (LUs) is different, and I haven’t specifically talked about this yet. I said before that goods depreciate or are consumed, which means the cost of those things in LUs is being lost from society. But I didn’t mention what happens with services. Think, for example, of a massage. Are any LUs lost from society? Nope. The payment the masseur receives is simply a redistribution of LUs. There is an opportunity cost, however, because that labor is not going directly to gleaning more wealth from the land or finding a way to decrease the daily Labor Unit cost of living for society. But it certainly improves quality of life! We could list out a bunch of different types of services and find that some of them do directly or indirectly increase society’s wealth (the labor of a farm hand, for example) and the rest do not increase society’s wealth but don’t cause it to lose any LUs either (other than the opportunity cost).

Second clarification point: I want to look back at the paint maker for a second to illustrate how this way of thinking about the cost of things in terms of Labor Units explains the profit of a business. If black paint suddenly becomes popular and the paint maker is able to increase his prices from 10 LUs/can to 15 LUs/can, he’s earning an extra 5 LUs/can. If his actual costs, not including his labor, of making a can of paint are 5 LUs, and it takes him an average of 2 hours to make a can of paint, he used to be earning 2.5 LUs/hour. But now with the price increase, assuming his costs are about the same, he is making 5 LUs/hour. Any price increase or decrease serves to increase or decrease the number of LUs someone is earning per hour of labor. If an entrepreneur builds a successful business and sells it for a large sum of money, that means each hour of work he put into that business ultimately yielded a very large number of LUs. I guess one could say that the profit they earned is how many more LUs they received relative to what they originally valued their time at, but it’s semantics at that point.

Ok, now on to a discussion of leverage. We hear about personal leverage and business leverage, but I want to introduce the idea of societal leverage, especially as it relates to fractional reserve banking.

When people think of leverage, I think they usually know it generally has to do with borrowing money, which increases risk but also increases the potential for greater gains. This is a good starting point. I’ll avoid getting too much more specific than that because it can get unnecessarily complicated.

But I will introduce one way to calculate leverage. It’s pretty easy, especially when viewed from an individual-level example. If a person has a house worth $400,000 and he still owes $200,000 on it, his debt is $200,000 and his asset is worth $400,000, so 50% of his asset is borrowed. In other words, he is 50% leveraged.

On a societal level, we could similarly say that leverage is a measure of how much of the society’s wealth is borrowed. But should this refer to the percent of society’s total wealth (cash and non-cash), or should it just be taking into account society’s cash wealth?

There’s no right or wrong answer here; there are just more-useful and less-useful choices for our calculation. And the usefulness depends on the question we’re trying to answer.

In our case, I want to know how at risk a society is of defaulting (i.e., having something happen that really ruins the society’s overall wealth and impairs its ability to make good on debt payments). We could call it a “societal default.” What constitutes a societal default? Well, thinking about the biggest things that ruin a society’s overall wealth, two come to mind. The first is a major bank declaring bankruptcy. We haven’t yet talked about how that could happen, but we’re getting there. The second is the government defaulting on its debts. I’m including that one because government financial trouble really does impact the wealth of the entire society in a significant way. I guess a potential third thing that could constitute a societal default would be if a large percentage of people in society all default on their debts at the same time, but I’m not sure how that would come about without at least one of the other two things happening, so I’ll leave that one alone.

I’m sure there’s a really erudite way to precisely define “societal default” and then use a whole bunch of historical data and come up with a really cool calculation that integrates all those factors into a single overall number that closely correlates with the risk of a societal default, but that kind of sounds like a PhD dissertation. So we’ll table that for now and just discuss some general things about the two main causes of societal defaults.

Bank Bankruptcy: In our fictitious society, remember that originally we only had 10,000 Goldnotes, but then the banker eventually printed an extra 23,000 of them? By then, the bank had issued 33,000 total Goldnotes, 23,000 of which were basically money borrowed from depositors (see the explanation of this in Part 10), which leads to this calculation just like I illustrated above with the house example: 23,000 / 33,000 = 0.7. So Pepper Bank is 70% leveraged. Note that 1 – Reserve Ratio = Bank Leverage (specifically on the bank’s receipt money it has issued). So a bank with a 30% reserve ratio is 70% leveraged. Even if a bank has a lot of other assets, if those assets are not easily sold to get more cash to keep up with withdrawals, low reserve ratios can be a pretty risky proposition.

I did some searching about historical reserve ratio requirements, and this article written by some people at the Federal Reserve said they were originally instituted in 1863 with the passage of the National Bank Act. The initial requirement was 25% (75% leveraged, that is), but in 1913 the reserve requirement was lowered to 15%, plus or minus a little bit depending on the bank type, with the passage of the Federal Reserve Act. Then the reserve requirement was lowered again a few years later to 10%. I won’t chronicle all the changes and how they may or may not be a causative factor in various booms and busts in America’s turbulent financial history, but think of the monetary expansion that would have caused! Speculation city when you’ve got that much cash suddenly available for borrowing!

In the 1980s, the requirement was 12%, then it was lowered to 10% in the early 1990s, and then finally in 2020 the Federal Reserve lowered the ratio again, this time to 0%. Yes. That means banks are currently 100% leveraged. Wow. That’s risky and is just asking for bankruptcies or bailouts (we’ll get to those too).

Government Default: This one should be calculated a little differently because the denominator (i.e., the total asset value) of the leverage calculation we’ve been using is difficult to ascertain. So instead let’s use the same number that banks use when they’re deciding whether to give an individual a loan. They look at the individual’s monthly income and then add up all the debt payments they have to pay each month. They generally won’t give a loan so large that, when you add in the new loan’s monthly payments, the person has to pay more than about 1/3 of their total income each month to all their debts. So, the calculation would be Total Monthly Debt Obligations / Total Monthly Income = Leverage. This seems like a good measure to use when considering a government’s risk of default as well.

Currently, the U.S. federal government spends about 10% of its revenue on loan interest payments. This number does not include any payments on the loan principal. That’s not super terrible, as government debts go. For comparison, state governments in the 1830s and 1840s racked up huge debts for infrastructure investments and were having to put a much higher percentage of revenues into their loan payments. The specific numbers are not readily available online, but they were sometimes greater than 50% of revenues, as documented in the book America’s First Great Depression, which is a book I mentioned before. Of course, these were payments on the interest and principal.

Depending on how much of a government’s annual expenditures are discretionary as opposed to mandatory, even 15% of a government’s revenue going to servicing the debt could be a big problem if revenues go down too much.

I don’t know what the “safe” amount of societal leverage is for either one of those two explained above. But the intuition should be clear that higher bank leverage and higher government leverage both mean higher risk of societal default. And a societal default is something we really want to avoid because the costs can be so huge. The great depression is a good example of the repercussions of a societal default.

Well, there’s an introduction to societal leverage. This is a difficult topic to write about because my ideas aren’t completely consolidated yet and because it is related to so many things that I haven’t yet written about. But I hope these ideas prove useful as we move forward deciding whether the risks of fractional reserve banking justify the benefits. Part 15 here.

The Theory of Money, Part 13

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Last week, we talked about the counterfactual to fractional reserve banking, which led into a new discussion of comparing and contrasting those two options to see which is better for society. So let’s continue that today by first discussing the two different ways banks can store specie. It seems like a random thing to talk about, but you will see that it has implications on how money evolves in the society.

First, for anyone who has read Harry Potter, you know about Gringotts Wizarding Bank. They store each depositor’s gold coins and other valuables in individual vaults.

The other way to store specie is by making one giant pile of coins in a single big vault a la Scrooge McDuck.

So the two options for specie storage are the Gringotts style and the McDuck style.

If Pepper Bank had stored each individual depositor’s gold coins on their own shelf in the vault (Gringotts style), that would have worked fine until Goldnotes came along. But when people started transacting with Goldnotes, someone could spend their entire savings and all that gold would still be sitting on their shelf. The coins on individual shelves/in individual vaults has become meaningless. All that matters is if you possess Goldnotes. Therefore, the coins have been anonymized–that is, no coin in the vault, regardless of whose shelf it’s on, can be attributed to any one specific owner. So, shelves or no shelves, the specie storage style of Pepper Bank automatically shifted to the McDuck style once receipt money was implemented.

This is what opened the way to fractional reserve banking, because now nobody can know whether their coins are still in the vault. Anybody could request to see the piles of gold coins in there, and they would be satisfied that there are way more coins in there than Goldnotes they possess. But it wouldn’t tell them whether are enough coins in the vault to redeem everyone’s Goldnotes.

So if we transition to receipt money, which I’ve said is a good idea, how do we prevent bankers from printing excess receipt money and lending it out? In other words, how do we prevent bankers from instituting fractional reserve banking, with all its associated inflation and lost savings and extra profits for bankers?

We need an auditing system. It would be rather simple. The banker would be required to keep track of how many Goldnotes are in circulation, and then the auditor would do a surprise visit to the bank several times per year and look at how many Goldnotes are circulating and then count up the total number of gold coins in the vault. The number should match.

Remember that when Pepper Bank switched over to using Goldnotes instead of deposit certificates, it meant that there were no more account balances to keep track of. The only thing a person needed was a Goldnote to be entitled to a gold coin.

In modern times, it would be a little different because banks do keep track of how much they owe each depositor. That’s what your “account balance” is. In this case, if the reserve ratio is 30%, then you just need an auditor to compare the total of all the depositors’ account balances to the amount of money in the vault. If the amount of money in the vault is at least 30% of the total of the account balances, then they’re good.

Anyway, an auditing system like the one described for Pepper Bank would allow our fictitious society to have the benefits of receipt money without the banker being able to take advantage of the receipt money-induced gold coin anonymity and institute fractional reserve banking.

Next week, we’ll get back into looking at the effects of fractional reserve banking. There’s still more to process with that one!

The Theory of Money, Part 12

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Re-reading last week’s post, one small thing that I should have said specifically about inventions is that, ofttimes, they increase the number of LUs a person can generate per hour of work. For example, the tractor that decreased the harvest time from 800 hours to 200 hours enabled the farmer to earn a lot more LUs per hour harvesting. So innovations can lower the number of LUs it costs to sustain a society, and they can also increase the number of LUs gleaned from the earth that will circulate through society. These are the two ways that the wealth of a society increases a lot faster!

All right, so where are we now? Our society’s money has evolved all the way to fractional reserve money (see Part 10), which means the receipt money (Goldnotes) that used to be 100% backed by specie is now, according to the banker’s self-imposed limit, only backed 30%. The society went from having 10,000 Goldnotes in circulation to 33,000 in circulation, the extra 23,000 of them being created out of nothing when the banker printed them to lend out.

Those loans, as we discussed last week, can be a boon to a society by enabling innovations to come forth that help progress the society toward greater aggregate wealth. But I also said those loans come at a cost. What cost?

Let’s say each Goldnote (or, really, each gold coin that the Goldnote entitled the bearer to) originally represented 5 LUs before the transition to fractional reserve money. 5 LUs x 10,000 Goldnotes = 50,000 LUs stored in the form of cash assets in society. And then the banker printed an extra 23,000 Goldnotes, so what happened to the Goldnote:LU ratio? No new Labor Units were generated when he printed those extra Goldnotes (wealth doesn’t come out of nothing–it comes out of the earth!), so the number of total LUs saved by society hasn’t changed. Thus, our new Goldnote:LU ratio is 33,000:50,000, which means each Goldnote is now worth only about 1.5 LUs, which is about 30% of what they were worth before. This means that when the banker printed all those extras, he took 70% of everyone’s cash wealth from them! They didn’t know it at the time, but their hard-earned Labor Units were being taken from them to furnish all those loans. And the only one who will profit from all of this is the banker, who will be earning interest on all the loans he owns.

And what do you think will happen to prices when Goldnotes are suddenly only worth 30% of what they were worth before? Yes, eventually prices will adjust to be approximately triple what they were before.

So, the loans were a boon to society, but they came at the cost of everyone losing 70% of their cash wealth, plus they imposed another major cost to society–that of some serious economic inefficiencies that arose from prices dramatically shifting.

There are some other costs to fractional reserve money that I haven’t discussed yet: booms and busts (and the bank failures that go along with them), and the evolution that always seems to happen from fractional reserve money to fiat money with all of its weaknesses. I’ll be explaining these in due time!

Overall, will the benefits of the innovations fueled by those loans outweigh all those costs to society?

In the long term, it’s possible. But let’s consider a counterfactual.

What if the banker, instead of switching the society to fractional reserve money, instead said, “All this gold is just sitting around doing nothing. And there’s that entrepreneur who’s looking for a 5-year loan to build his gas car factory. I’m going to ask my depositors if they’re willing to allow me to lend any of their cash savings to the entrepreneur for those 5 years and, in return, I’ll pay them a portion of the interest I charge him.” So the banker asks around and it turns out that, in aggregate, his depositors are willing to lend out 7,000 gold coins.

How exactly would this lending work? Let’s say the farmer originally deposited 400 gold coins in the bank and still has all 400 of those Goldnotes in his possession. He agrees to lend out 300 of his Goldnotes, so the banker takes the 300 Goldnotes from the farmer and, in exchange, gives him a certificate that says, “This entitles the farmer to 300 Goldnotes in 5 years and 1 Goldnote monthly in interest until then.” Yep, it’s a bond, which has always just been a fancy name for the piece of paper that someone gets when they lend money to someone.

The entrepreneur got to borrow 7,000 Goldnotes to build his factory, and no inflation was caused!

Having only 7,000 Goldnotes to lend (instead of 23,000) means much less investment in potential wealth-generating innovations. Those other entrepreneurs who would have borrowed money will just have to wait until society has more to lend. Or, they could find outside funding from another society, which would work just as well.

Which version of reality is better?

On the one hand, with fractional reserve banking, you’ve got a lot more investment earlier on, but it comes with several major costs, including people losing 70% of their cash wealth without having any way to stop it (while the banker gains a bunch of wealth by taking all the interest from loaning all that money!), dramatic price shifts and the economic inefficiencies they induce, the significant risk that the society’s money will continue all the way down the path to fiat money with all its issues, and the booms and busts and bank failures that monetary expansions and contractions can cause.

And on the other hand, you’ve got less investment earlier on, but there are no major costs to it.

Over the next few weeks, I’ll delve more into the downsides of fractional reserve banking, which will help us better quantify them so we can weigh them against the upsides.

The Theory of Money, Part 11

Photo by Jannis Knorr on

I introduced so many new things last week that I might need to take a few weeks to process them before progressing further in our society.

First, I said that this new gas cars business venture will be very beneficial to society if it works. Why?

Remember how I said many weeks ago that all of society’s wealth originally is gleaned from the land (mixed with labor)? And remember how we are quantifying wealth in units that I’ve been calling Labor Units (LUs)? Well, what happens to those LUs after they’ve been gleaned is they get distributed throughout society as people provide goods/services for each other and get compensated.

So the LUs are spreading around from person to person, but do those LUs ever get consumed/lost from society? Or do they just keep circulating around and around forever?

Think of the blacksmith that painted his house black. That paint is slowly going to wear off over the next several years, and then he’s going to have to paint his house again. So if the paint cost 10 LUs to make, those 10 LUs are now lost from society. But that’s better than not painting his house and the whole thing rotting, which might lead to a loss of 10,000 LUs from society.

Or think of the farmer feeding his family with part of his harvest. Every bit of food that is eaten is LUs that are lost from society.

Maintaining a human society costs LUs every day. All things are depreciating, so they are all dissolving away LUs each day. And if there are lifestyle changes (for example, that people decide they want to live in larger houses that now depreciate more LUs per year than their previous smaller houses), the daily cost of maintaining that society increases. And as long as the society can afford it, this is not a problem.

But it’s wonderful when there are innovations that decrease the daily cost of maintaining a society . . . innovations like gas-powered cars and tractors. If the farmer and his farmhands used to spend an accumulated 800 hours of labor per year harvesting grain, but then the farmer buys a tractor that cuts the harvesting time down to 200 total hours, he has just saved 600 hours of labor. And assuming at least some of that extra time is put into working to glean more LUs from the land (say, he expands the number of acres he uses the next season), this innovation has now increased the overall wealth of society. I’m assuming here that the depreciation cost of the tractor is lower than the additional LUs it enabled the farmer to glean.

Ultimately, this is how we progressed from hunter-gatherer and agrarian societies to our modern-day societies filled with more wealth (and spending more LUs per day) than humans even a couple hundred years ago would ever have imagined. It happened one invention at a time–the loom, the printing press, electricity, the lightbulb, the internet, etc.

And inventions often require capital to develop and disseminate. Without enough investment into these ideas, nothing happens with them, and the wealth of a society doesn’t progress.

So that’s why I said the banker’s loan to the entrepreneur provided a great service to society. All of his loans have a chance of paying off bigtime to society.

But these loans come at a cost as well. We’ll talk more about that next week.

The Theory of Money, Part 10

We talked last week about the characteristics of optimal money and found that Goldnotes actually do a little better than gold coins.

This week, let’s move forward and see what further changes this shift to receipt money leads to.

First, let me add a new term. The general term for intrinsically valuable stuff being used as money (whether the society is using gold or corn or cigarettes or anything else intrinsically valuable) is specie. Not to be confused with species.

Ok, now let’s get back to our fictitious society to see what happens next.

Pepper Bank has become a very successful business. After the banker introduced Goldnotes, everyone in society started storing their excess gold coins in Pepper Bank because Goldnotes came to be preferable to having to carry around gold coins.

The banker, however, wasn’t finished with finding ways to make money. Now that Goldnotes were being used primarily instead of gold coins, he always had the majority of everyone’s cash wealth sitting in his vault, and he was charging them a small fee every month to do so. But he would look in his vault every day and think that all those piles of gold were just sitting there doing nothing. What a waste.

He, being a banker, was tracking pretty closely the day-to-day changes in how many gold coins he actually had sitting in his vault. He found that he was usually up around 10,000 gold coins, but it could go as low as 8,000 depending on the time of year and other factors. And he knows it has never gone below 7,000 ever since society shifted to primarily using Goldnotes. So he gets an idea. He says to himself, “Self, what if I lend out those extra 7,000 coins that are just sitting there doing nothing?”

They’re not his gold coins to lend out–they’re his depositors’ accumulated savings. But since nobody is going to need them, he figures it won’t hurt if they’re not in his vault for a while until the loan gets paid back. And he will still be holding in reserve in his vault enough gold coins to satisfy all the demands for specie. If his average is 10,000 gold coins and it has never dropped down below 7,000, he figures he only needs to keep about 3,000 gold coins in his vault at any given time and he’ll be perfectly able to meet any demand for specie.

Carefully, he starts testing this out. An entrepreneur recently moved to town and has been talking about a big idea to start building gas-powered cars, but he needs a ton of capital to first build the factory. The banker and the entrepreneur talk and, after working out the details, they agree to the terms for a loan and the banker lends those extra 7,000 gold coins to the entrepreneur. But they realize the entrepreneur is just asking for a highway robbery if he takes a big cartload of jingling coins, so instead the banker prints 7,000 extra Goldnotes and puts them in a bag for the entrepreneur to take home with him.

This is a great service to society. This new business venture, if it succeeds, is a big step toward enhancing the wealth of this society, and I’ll need to spend more time in future posts discussing why. But for now let’s stick to looking at the banking aspects.

When the banker prints those 7,000 Goldnotes and gives them to the entrepreneur, it is the first time that there are more Goldnotes out in circulation than there are gold coins in the bank. This is a big change. But nobody knows it; they assume the banker is rich enough from all the fees he’s been charging and from being a gold prospector before to lend out 7,000 of his own gold coins.

Fortunately, he was conservative in how much he was willing to lend out, so he always has enough gold coins in the vault to give people in exchange for Goldnotes any time they want, so they’re none the wiser.

In fact, something surprising happens over the next few months after he gave the entrepreneur those 7,000 Goldnotes. He now has 17,000 Goldnotes in circulation, and he finds that he still never has specie requests that total more than 30% of that (just like before), which means the maximum he ever has to redeem is 5,100 gold coins. But he still has 10,000 gold coins in the vault, remember? So he still has 4,900 excess gold coins in the vault just sitting there doing nothing!

So he goes out and again finds someone who wants to borrow some money. This time, he is willing to lend out 4,900 gold coins. So he does, and again he gives the borrower 4,900 Goldnotes instead of giving him a cart-full of gold coins.

He then again watches how his gold coin reserves look for several more months, and he finds that, again, demands for specie never exceed 30% of the total Goldnotes in circulation.

How many Goldnotes are now circulating? With his original 10,000 Goldnotes, plus the two loans, that makes 21,900 in circulation. And demands for specie never exceed 30% of that, which means he only ever needs a maximum of 6,570 gold coins in the vault. But he still has 10,000 gold coins in the vault, which means he still has 3,430 gold coins in excess just sitting there in the vault not doing anything.

This is the point where he realizes he could go through this cycle over and over, and each time the number of excess coins would be smaller. Ultimately, he gets mathematical and derives a formula, 1 / fractional reserve = the money multiplier. The fractional reserve is the percent of specie he needs to keep in the vault (he settled on 0.3, or 30%, as a safe number). The money multiplier says how many Goldnotes he can print for every gold coin in his vault. 1 / 0.3 = 3.3 (rounded), so 10,000 gold coins x 3.3 = 33,000. He can have in circulation up to 33,000 Goldnotes based on his 10,000 gold coins!

He only has 21,900 Goldnotes in circulation so far, so he decides to print another 11,100 of them and loan them out. Finally! His reserves get pretty low sometimes, but true to his historical trends, they never go all the way down to 0.

The banker is very happy. He ends up having about 33,000 Goldnotes out in circulation, and 23,000 of those are ones that he lent out, so he is earning interest on 23,000 Goldnotes every month! And he doesn’t have any more gold coins just sitting in his vault doing nothing.

This is called fractional reserve banking.

Is this wrong? Are new Labor Units being created? Certainly the society feels like it’s booming because it’s suddenly flooded with capital. There is a lot to process with this change, which we’ll do in the coming weeks, but my final point this week is that we just transitioned to yet another type of money!

We started with commodity money, which then shifted to receipt money when the banker created Goldnotes, and we decided this was an upgrade because even though the paper itself was almost worthless, it entitled the bearer to a gold coin, so it was still 100% backed by a commodity of intrinsic value. And now we have shifted to “fractional reserve money,” which still entitles the bearer to 100% of the stated value, but there’s only about 30% of specie actually in the bank compared to the total number of Goldnotes in circulation. So in an aggregate perspective, our money supply is only 30% backed at this point. If the reserve ratio had been set at 20%, the money supply would be 20% backed. The lower it goes, the riskier things become, which we’ll discuss in coming weeks.

The Theory of Money, Part 9

Last week, our gold prospector became a banker. And then he precipitated a change in the society to shift from commodity money to receipt money. (I originally named his receipts goldpaper, but I think Goldnotes is a better name, so I changed it.)

As is often the case, in the intervening week since writing the last post, I’ve been thinking about some things that I want to clarify.

First, I’ve never given my official list of all the characteristics of optimal money, and I think that will be useful moving forward. So, here’s my list so far:

  1. Intrinsically valuable: This requires two things. Whatever is used as money needs to have some use independent of its use as money. But that alone isn’t enough. If something is freely available without exerting any labor to procure it, it won’t necessarily cost anything even if it does have an important use. Oxygen at sea level, for instance. So the second requirement is that labor needs to be exerted to procure it, which now puts a price on getting it. The importance of this becomes clear when I get to the second characteristic . . .
  2. Value is stable over time: This requires supply and demand to be stable over time. Or, if one rises, the other will rise with it so that the value remains approximately the same after the adjustment. Of course, demand will change for all things over time as new uses–and also new substitutes–for it are found. Economic shifts also affect the demand for things (notably, luxury items will be less desirable when there’s a recession). But as long as labor needs to be exerted to procure the thing being used as money, the supply of it will be linked to demand through market effects: If the demand goes up (and price rises along with it), suppliers will work harder to procure more; if demand goes down (and price decreases along with it), suppliers will not procure as much because it may no longer be profitable to continue using the marginal capacity that they added.
  3. Nonperishable
  4. Easy to determine the quality/value of it: If metal is being used, this is easier to determine the purity and weight (and, therefore, the value) than, say, a cow, or a share in a new business.
  5. Can be precisely measured: This is similar to the last one, and these days there isn’t as much of a challenge in measuring things, although back in the day this would have been an important consideration, especially if the type of money being used had a very high value-to-weight ratio, because that would require especially precise measurement instruments.
  6. Easily divisible into the right amount for payment, and dividing it doesn’t alter its value: A live milk cow cannot be easily split into smaller values. Something like corn, on the other hand, meets this criterion perfectly. Or metal that can be melted and divided into different sizes, although that’s not as easy to divide as corn.
  7. Not too heavy: People would rather not be burdened by having to carry really heavy money.
  8. Value-to-size ratio is in the sweet spot: If buying something takes a whole wagonload of money, that’s inconvenient, even if it isn’t very heavy. On the other end of the spectrum, if you’re using diamonds for money, even losing a tiny diamond is a significant loss.
  9. Impossible to counterfeit

There might be other things I’ve missed, but that’s what I have for now. Obviously nothing will meet all those criteria perfectly, but it gives us a standard against which we can evaluate any money. So why don’t we do that right now and see how well gold coins and Goldnotes do?

I won’t go through every criterion listed above for each, but we can at least cover the highlights pretty easily.

Gold coins: Looking through the list, gold coins do a great job overall. They’re a little heavy maybe, but at least they’re fairly small (without being too small), and different-sized coins can be minted quite easily to suit different values. I said our blacksmith figured out how to counterfeit gold coins, but that was admittedly not super believable, and in modern times it would be very difficult to counterfeit gold coins and get away with it for long.

Goldnotes: Your first impression may be to think that it doesn’t meet the first criterion, but remember what I said last week–Goldnotes are directly backed by something that is equal to their stated value, so as long as you can reliably exchange a Goldnote for a gold coin then it’s not a problem. This is an important caveat, as will become clear over the next few blog posts. In some ways, Goldnotes actually do a lot better than gold coins. They’re lighter and easier to stack and carry. And their value is actually more reliable. Historically, when societies shift from metal coinage to receipt money, the banks automatically do an appraisal of each coin they receive to ensure its stated weight and quality is accurate. People couldn’t get away with clipping off the edges of a gold coin and passing it off as a full coin to the bank! Our blacksmith never would have gotten away with his counterfeiting had there been a bank around performing this service when it accepts deposits. Therefore, historically, because the receipt money’s value was more reliably known than the coins themselves, receipt money actually traded at a little bit of a premium compared to coins. So, because Goldnotes are lighter and more reliable in their value, I’m going to declare this shift from gold coins to Goldnotes an upgrade to a better currency! Thanks to the banker.

The other thing I’d like to clarify is standardization of gold coins. I’ve just been talking about them all along as if 1 gold coin was a set weight and quality. This doesn’t happen automatically of course. You could forego standardization and go around using little nuggets instead, but everyone receiving gold as payment would have to have the means of weighing them and assessing their purity. So standardization makes using metal coins much easier to use for exchange.

Historically, this is where governments would help. For example, the solidus (AKA bezant) was a gold coin minted by the Roman and Byzantine empires for several centuries. It weighed about 4.5 grams and was 24 karats. So presumably someone who found a gold nugget could take it to a mint, where its purity would be verified and, for a fee, it would be stamped into a standardized hard-to-counterfeit shape.

I won’t get into how governments figured out that they could mint them with a little less gold for the sake of keeping some for themselves, but that happened too and generally led to the failure of the coins as reliable currency.

Clarifying these details took enough space today that I’ll save the introduction of “fractional reserve banking” for next week. That’s where things really start to get crazy.

The Theory of Money, Part 8

We’ve talked about a lot of stuff by now, and the reasons for all of it will start to become clear as we progress our imaginary society toward a more modern money society.

So, let’s say a gold prospector visits the region and finds a new gold deposit in the mountain right next to the town. He establishes a mining operation there and moves to the town himself. He wants to safely store all this gold he’s mining so it doesn’t get stolen before he can sell it, so he builds into his house a huge safe.

Meanwhile, tragedy strikes. The farmer, who was storing his extra gold coins under the floorboard in his room, had a break-in when he was out working in his fields. The burglar found his emergency stash of gold coins and took them. That was several weeks’ worth of labor that he lost!

Suddenly everyone in town is a little more hesitant about storing their hard-earned Labor Units in their house. And they have all been doing that because they’ve been so industrious and have all accumulated some wealth that they’re storing primarily in the form of gold coins. That’s when they remember that the prospector has a large and secure safe in his house, so they make a proposal: “How about you store our gold savings in your safe for us? There’s excess capacity anyway in there. In return, we’ll pay you a small fee each month to do so.”

It’s a no-brainer for the prospector, and voila! Our town has a bank, and he has become a banker. And since he loves spices, he names it Pepper Bank.

Each time a person brings some gold coins to store, he carefully counts them out and makes two copies of a piece of paper. He gives one to the depositor and keeps one in the safe. The papers say how many gold coins that person has stored in Pepper Bank. And each time they visit him to put more money in the bank (or take some out), he updates the papers.

What a relief. The townspeople have a solution to their worries about break-ins. Because even if the burglar strikes again and steals someone’s deposit paper, it’s worthless. The burglar can’t show up to Pepper Bank and expect the banker to give him the person’s gold coins!

Then one day, the banker has an idea. It would be much faster for him to simply work with the town printer and make a bunch of little pieces of paper that each state, “The bearer of this paper is entitled to 1 gold coin at Pepper Bank.” And it would also be convenient for the townspeople because then they wouldn’t have to carry around bags of gold every time they wanted to buy something. They could instead use these pieces of paper for their transactions. The downside of switching over to this system is that those pieces of paper are steal-able, but at least a little stack of papers would be easier to hide in a house than a chest of coins, and the added convenience probably outweighs that downside.

The banker also thinks that if people start using the paper for transactions, more people will end up storing their gold coins in Pepper Bank, so he will earn even more money off storage fees!

What should he call these pieces of paper? Initially, he decides to call them gold coin receipts, but that’s too long and awkward to say, so it eventually gets shortened to Goldnotes.

So the banker visits every depositor and shares with them his new Goldnotes idea, and they love it, so he gives them each the appropriate number of Goldnotes to represent the number of gold coins they have already saved in his bank. And from that point on, he always gives Goldnotes in exchange for gold coins stored in his bank. He cautions everyone not to lose any Goldnotes because there will be no way to prove that they didn’t give the papers to someone else. But he does say that if a Goldnote is getting old and torn, they can bring it to him and he’ll exchange it for a nice fresh one.

Pretty soon, the townspeople are making exchanges both with gold coins and Goldnotes, because they have found that any time they present to the banker a Goldnote, he will trade it for a gold coin.

Well there you have it. We have finally made the transition to a new kind of money! We started with commodity money, landing on precious metals as the most convenient kind of commodity money, and now we have receipt money.

Is it ok that these Goldnotes are, themselves, nearly worthless? Yes, because they are 100% backed by a commodity equal to their stated value.

This is just like the title to a house. The title itself is nearly worthless (a piece of paper and some ink), but it is 100% backed by an asset, so whoever owns that title has claim to the asset that backs it.

Next week, we’ll talk about what the banker decides to do when he sees all that gold just “sitting there doing nothing” in his vault.

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